The Four Levers
A manager can pull only four levers to increase a firm's profitability: sales, variable costs, fixed costs, and price. When a manager bumps up his firm's advertising budget to gain a larger market share, he's pulling the sales lever. If he has found a cheaper way to source raw materials, he is pulling a variable cost lever. If he tries to reduce his firm's overhead, he is pulling the fixed cost lever. Yet for some reason, not all these levers are treated equally. Price, in particular, is neglected. This is peculiar because a number of studies have found that although rarely pulled, the price lever is the most efficient way to increase a firm's profitability.9 We updated these studies by applying the same methodology to the most recent company data available through Wharton Research Data Services (WRDS), as shown in Figure I.1.
Figure I.1 Impact of profit levers in U.S. in 2004
As Figure I.1 shows, our analysis essentially reconfirms previous studies. We find that if a firm can cut its fixed costs by 1% without affecting its operations, its profitability can increase, on average, by 2.45%. Similarly, if a firm can increase its sales by 1% without changing its cost structure or price, the firm's profitability can rise by 3.28%. The effect of lowering the variable cost by 1% is larger: Profitability can increase 6.52%. However, the effect of improving a firm's price by 1% is the largest of all: 10.29%. Remarkably, as Figure I.2 shows, this effectiveness ranking order holds for each of the eight industry groups using the standard industry classification (SIC) scheme.
Figure I.2 Impact of profit levers in U S. by industry (2004)
A pessimist might conclude from these numbers that price isn't a lever that one should pull lightly: If the upside benefit of pulling that lever is high, the downside risk or the difficulty involved in pulling that lever must be substantial, too. Otherwise, why wouldn't firms pull that lever more often? Indeed, some managers would quickly add that it's not practical. "It is one thing to cut costs by 1% without affecting everything else, but it is entirely something else to improve your pricing by 1% without changing anything else. For one thing, sales will drop!" For that reason, the pessimist might see the promised double-digit increase in profits as a dangerous illusion. It might seem far more prudent to pull the other three levers instead of risking everything on a single number.
However, an optimist would see from these tantalizing numbers a holy grail for profitability. How often could one identify and work with something that can lead to a double-digit increase in a firm's profitability by just changing a few numbers? The fact that a firm is not pulling the price lever only means that it is missing a big opportunity. After years of diminishing returns with the other three levers, the price lever might just be the best bet. In any case, it's certainly the easiest: Companies can make price changes quickly—hashed out over a bottle of Bud, then approved at the stroke of a pen.
When it comes to the potential of pricing, both the optimist and the pessimist have valid points. However, we believe the optimists have the edge. No strategy is risk-free, but after years of teaching pricing to our MBA students and executives and consulting to pricing managers all over the world, we believe companies willing to pull the price lever face more promise than risk.